Creating Smarter Financial Regulation

This Joseph Keppler illustration from 1901 shows that Wall Street bubbles are nothing new

Yale’s School of Management wants the nation’s regulators to learn the lessons of the financial crisis, and they’re designing a new program to help them do it. When Wall Street hit the skids in 2008, it was Main Street that largely paid the price. Andrew Metrick, professor of finance at the Yale School of Management, says one reason is that regulators weren’t looking in all the right places in the years before the crash.

"When we would regulate financial institutions we would do it in a way that was called microprudential," said Metrick. "We would look at the individual institutions and make sure they were on a one-off basis, just themselves, safe. We learned that the interconnections between institutions were a lot more important than we thought."

Now, instead of that microprudential approach to regulation, Metrick wants the focus to become macroprudential – in other words, examining interconnections in the financial web, as well as the way overall fiscal and monetary policy affects the health of financial institutions. "Nobody really knows how to do it, or has been training to do it," said Metrick. "And the academic literature itself is fairly young, so our new program on financial stability aims to fill that gap."

Metrick says despite the fact that no one’s addressed this yet in academia, he’s not short of source material as he goes about designing Yale’s new program: "The nice thing about a huge financial disaster – there are very few nice things – but one nice thing is that there are a lot of investigations that come out of it, and from those investigations, many reports get published that have a lot of detailed information about what went wrong. So we’re a little bit like the FAA after an air disaster, picking through the wreckage to figure out what happened."

Next summer, Yale hopes to host about a dozen keen minds from the world of regulation. That summit will aim to figure out how to incorporate the latest thinking and academic discoveries about the discipline into current practice. "We’re in contact with major regulatory agencies, central banks and financial market regulators," Metrick said, "to send us really up and coming PhD economists from their organizations that they expect will be playing an important role in financial stability issues."

Of course, no one welcomes a visit from the regulators, and it isn’t so long ago that Wall Street was arguing the case for a lighter and lighter regulatory touch. So is the need for more regulation now a settled question? Metrick says there’s wide acceptance of the need for the macroprudential approach: "Those things everyone recognizes we need to pay attention to now, it’s just how significant of a constraint we should put on financial institutions – that’s subject to a lot of debate."